Finding Potential Among the Sleepers

 | Feb 06, 2014 | 4:00 PM EST
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One of the problems with being a deep-value investor is separating the stocks that have a high survivability factor from those that are just bad companies without much rational hope for recovery.

I use a lot of different tools in this search, and one of the more valuable screens I run in this search is based on a chapter in Aswath Damodaran's excellent book Investment Fables. In the book he looks at many of the more popular investment approaches, including growth and value techniques. If you have not read it, I encourage you to do so today. I keep my copy within arm's reach.

Damodaran examines the returns of stocks that trade at a discount to tangible book value and finds that cheap stocks that have low leverage and respectable returns on equity deliver outstanding returns over time. I have run this methodology through a quick-and-dirty back-test and found that stocks that fit these criteria have delivered almost four times the market's rate of return since 2000.  It is a pretty simple matter to run a screen to find these potentially winning stocks.

As with every other value-oriented screen I run, the list of qualifying stocks is pretty short, but there are some interesting names on the list. I have said before that I know nothing about gold and have no interest in owning shiny stuff or predicting the price path of the metal. However, it is becoming clearer every day that the gold-mining business is becoming undervalued. Unless everyone stops using the stuff for jewelry and industrial usage and investment demand dries up completely, gold miners are cheap. Newmont Mining (NEM) is one of the world's largest gold miners, and it makes the list of potentially winning stocks.

The company has assets in the U.S., Australia, Peru, Indonesia, Ghana, New Zealand and Mexico. Newmont is primarily a gold miner, but it does have copper mining operations as well. The stock is currently trading at 90% of book value and is earning a return on equity of well above our 8% cutoff point. This is the first time I can recall these shares trading below book value, and when gold comes back into favor, the stock could easily challenge the old highs, which are about three times the current stock price. It may be a long bumpy ride, given the psychological nature of gold trading, but patient investors should be well rewarded.

PartnerRe (PRE) is not a company that is going to generate a lot of interest in the media or around the various Internet chat sites, but it's a solid reinsurance company that generates solid returns on equity and is well capitalized. The company offers reinsurance in areas such as agriculture, airlines, general aviation and space, as well oil and gas operations. As with all reinsurance companies, there is an occasional hit when there is a string of losses, but most of them time the company just runs along, generating solid profits. The shares currently trade at just 80% of book value and appear to be a bargain.

Capital Southwest (CSWE) is one of those companies no one talks about, but it has done pretty well for its investors over the years. It's a business development company that makes private-equity investments. It has grown net asset value from around $18 a share 10 years ago to $50.25 at the end of 2013, or about 10% a year, compared with the S&P 500's 6.47% return over the same period. The return on equity is about 18% right now, and the shares are trading at about 70% of the asset value. It is worth your time to go to the company's website and look through its portfolio. Capital Southwest owns everything from banks to companies that clean oil and gas pipelines.

I have written about MFC Industrial (MIL) often, so I won't recap the company here. This commodity supply-chain concern company is also on the list, since it has a return on equity of 27%, and the shares trade at 70% of book right now.

I have found this screen to be very profitable over the years. It has turned up some huge winners, and it is an important part of my arsenal of tools for finding cheap stocks that have big potential.

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